The Issue

​If you’re in the habit of reviewing California residency cases (and only a tax attorney specializing in the field or a masochist would be), you will occasionally come upon a reference to the Franchise Tax Board’s “Integrated Nonfiler Compliance” system, sometimes called the INC program. The court opinion will mention that the audit was initiated under INC and move on from there. This article discusses how this somewhat secretive program works, and how it affects a nonresident’s risk of a California residency audit. Understanding INC is central to residency planning, particularly for former residents who no longer file tax returns in the state.

Good News, Bad News

The good news is that nonresidents are often in control of the actions required to minimize that risk. The bad news is it usually takes a concerted, systematic effort to avoid the INC system. A single mistake can earn you a residency audit.

Which Nonresidents Does INC Target?

The INC system only targets a certain subset of nonresidents. Specifically, as the somewhat sinister name indicates, it focuses on nonfilers. For nonresidents who in fact file a nonresident California tax return (Form 540NR), the FTB doesn’t need INC to decide whether to audit for residency or not. That’s because a 540NR delivers most of the relevant information to the FTB on a silver platter. The 540NR requires a nonresident to disclose the number of days spent in California during the tax year, ownership of California residential property (directly or indirectly through an entity or trust), and perhaps most importantly the nonresident’s global income. That’s usually more than enough material for the FTB to decide whether to pursue a residency audit, or at least to provide grounds for investigating the taxpayer further by reviewing available databases (including Google and Zillow) before deciding to go forward.

For nonfilers, the FTB doesn’t have any of that information. The purpose of the INC system is to provide some preliminary facts about nonresidents who don’t file a nonresident return in order to ascertain whether it makes sense to initiate a more formal information-gathering procedure. Usually that procedure is a 4600 Notice “request for tax return,” rather than a full residency audit. But a 4600 Notice is often the prelude to the more grueling full audit. For the details about what a 4600 Notice entails, see this article: California’s 4600 Notice “Request For Tax Return” – The Definitive Guide for Nonresidents.

In any case, if you are a nonresident who files a 540NR, you don’t have to worry too much about the INC program, but for all the wrong reasons: the FTB already has you on their radar scope. It should be noted, however, that averting the situations that fuel the INC process is a good idea in general in case you are in fact audited. In contrast, if you are a nonresident who doesn’t file a California tax return, then it’s important to know how INC works in order to prevent getting caught in its net.

The INC system is designed to identify nonfilers of any sort, nonresidents and residents alike. But this article focuses only on nonresidents, and as a factual matter the bulk of the notices generated by the INC system go to out-of-staters.

How The INC System Works

For the most part, when it comes to residency audits, the FTB is like reef coral – it sits and waits for unfavorable information about a taxpayer’s residency status to float by Sacramento. This happens with remarkable regularity, and is usually due to common mistakes made by nonresidents. However, the INC system is one area where the FTB takes the initiative in collecting residency-related information to investigate an individual’s residency status. Here’s how it works.

In the normal course of its operations, the FTB receives more than 500 million documents each year from federal and state tax agencies, financial institutions, municipalities, and other sources. The FTB inputs the information into the INC system, which runs a comparison with FTB records to determine whether a tax return has been filed by individuals who appear (using the system’s particular algorithms) to have reportable California-source income or otherwise may have filing requirements. The nonfilers on that list are then sent a 4600 Notice or other applicable demand for more information about their residency status.

The algorithms aren’t particularly discerning. Almost all the noticed nonresidents are able to resolve the matter in their favor, because in fact they can show they are nonresidents and don’t have a requirement to file a return. But it takes time and trouble to respond adequately. And a small percentage may wind up in a residency audit (or face a notice of proposed assessment if they fail to timely respond to the notice and default, which often happens with nonresidents with seasonally unoccupied second homes in California, where the notice may lay unanswered for months). But that’s neither here nor there for the FTB. The point of the system is to automatically notice taxpayers who may be worth investigating, and whose response provides the information the FTB needs to make a decision about whether the situation merits a residency audit.

By the way, while the vast majority of nonresidents who get caught in the INC system ultimately don’t have to file a nonresident return and are let off the hook, some in fact do owe California income taxes and may have to file a return as a result of California-source income. The reason may be as simple as spending lengthy vacations at a second home in California while working remotely for an out-of-state company for W-2 compensation. See the article: Working While Vacationing: The Perils of California Source Rules for Nonresidents. Or they may have angel investments in California that start generating profit after a long startup period, reflected in a K-1. Or they may rent out their second home when they aren’t using it. For most people, the amount of taxes may be minor. But for high-income nonresidents with significant California contacts, it’s all the more reason to discuss this matter with their CPA before receiving a notice from the FTB and facing the prospect of penalties and interest.

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The category that triggers the most FTB inquiries to nonresidents are information tax returns. By far

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Worse still, a few such taxpayers not only have to file California tax returns, but also maintain such extensive contacts with the state that they are in fact legal residents under applicable rules. Those taxpayers need to seek legal counsel in preparing a residency plan to avoid what might be a catastrophe. The test used by California is discussed here.

The INC Database

While the INC system receives hundreds of millions of documents, the categories that count with respect to residency audits are quite limited. They can be reduced to the following: information tax returns with your tax ID and a California address on them (Form W-2s, 1099s, 1098s, K-1s, etc.); active professional/occupation licenses issued by a California board; IRS audit reports for taxpayers with California addresses; business licenses with California addresses.

Let’s discuss each category separately.

The Big One: Information Tax Returns

The category that triggers the most FTB inquiries to nonresidents are information tax returns. By far. A typical situation involves a former resident who retains a second home in California (a former primary residence) after moving out of state, without systematically informing the entities that generate information tax returns of the taxpayer’s residency change. As a result, 1098s from mortgage lenders, 1099s from financial institutions, K-1s from investments, and so forth, continue to be sent to the California address. The nonresident may think nothing of it since they collect all the information tax returns at their second home during tax time anyway, just like they did when living as a California resident.

But the FTB doesn’t look at it that way. The INC system interprets information tax returns with a California address for the taxpayer as an apparent admission that the taxpayer lives in California. If the nonresident doesn’t file a return, a 4600 Notice is automatically sent, untouched by human hands.

In contrast, if the taxpayer did change the home address on the information tax return, then it’s still possible the FTB will inquire into the taxpayer’s filing or residency status, if the information tax return gets to Sacramento. But it isn’t automatic. An FTB examiner has to review the information to see if the situation appears innocuous or not (usually it is). For instance, if a 1098 Mortgage Interest Statement shows an encumbrance on a California home, but the taxpayer’s address is out of state, the examiner usually gets the picture that the taxpayer is a nonresident with a vacation home in California. The number of houses owned in California by nonresidents isn’t well researched, but a decent estimate is 200,000 units (there are about 7.5 million second homes nationally, with about an eighth of that number located in California, with indications that a third of that number involves nonresidents). Given that high figure, there’s little incentive for an examiner to audit a nonresident with a second home in California unless there are other indicia of residency or income-sourcing issues.

The same is true for 1099s from banks and brokerage firms. Every year, the FTB gets thousands of 1099s from financial institutions in California with out-of-state addresses for the taxpayer. That set of facts by itself usually doesn’t warrant further investigation.

IRS Revenue Agents Reports

Another consequential input to the INC system involves information provided by the IRS. Due to strict confidentiality rules, the IRS doesn’t share taxpayer data helter-skelter with the FTB. But it does provide certain details regarding federal tax audits involving taxpayers using a California address on a federal return. The targets are taxpayers who understated their federal income, or failed to file a federal return when required, and got caught, resulting in an unfavorable IRS revenue agent report.

So why would a nonresident use a California address on a federal return? The answer usually is, by mistake or out of misplaced emphasis on convenience. Some former residents leave the US to live overseas and use a relative’s or friend’s house in California as their address to make sure any notices from the IRS reach them in a timely manner. Some taxpayers move out of state but continue to use their former residence (converted to a second home) for tax contact purposes out of sheer habit. Or they mistakenly think that they should use their California address for a prior year return because they were residents in that year, even though the IRS filing occurs after they left California. Whatever the rationale, it’s never a good idea.

Note also that the IRS audit may involve a return going back a number of years. A substantial underpayment, for instance, could be audited up to six years after the filing. It then may come as a complete surprise to the nonresident to get a 4600 Notice out of the blue for a tax year that is a distant memory.

The takeaway is simple: never use a California address on a federal return once you move, even if you were a resident in the tax year at issue. But by “never” I mean, unless your CPA, having reviewed your tax return, says otherwise. All tax return filings are unique.

City/County Business Tax Program

The INC system includes information sharing with cities and counties that impose local business taxes. The way it works is, participating cities send the FTB their business license data. The FTB then matches this information with its records and sends notices to taxpayers with business licenses who didn’t file a tax return. The FTB reciprocates by correlating tax return data to the business license information to identify taxpayers who reported business income but have no city business license. The state legislature even passed a law to encourage this cross-referencing: Rev. & Tax. Code Section 19551.1 et seq.

It sounds slightly Orwellian, but I’ve only seen a few cases of 4600 Notices being issues on this basis. The information usually involves rentals subject to municipal codes, or businesses run out of a second home while the nonresident is in California. Needless to say, nonresidents who rent out property in California or run a business from a second home should consult their CPAs about their California filing requirements. It’s quite likely they have to file nonresident returns.

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This seems to be braggadocio on the FTB’s part, an attempt to make nonresidents feel they are being scrutinized more closely than they actually are

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By the way, as an aside, it’s not the end of the world to have to file a nonresident return. It does, however, usually increase your residency audit risk, especially if you spend significant time in California. Some attorneys advise nonresidents to file a nonresident return even if they don’t have to (that is, a zero-income-tax return), if only to start the clock on the statute of limitations. But that can be a bad idea if the profile projected in the return indicates residency (high income, significant time in California, ownership of a large, expensive home, a large liquidity event  shortly after changing residency, even if in another tax year, and so on). But that’s a separate topic.

Professional (Occupational) Licenses

The FTB purports to use occupational license information to identify nonresident nonfilers. Usually, this would be former residents who retained professional licenses in California after their move. This typically involves difficult-to-obtain licenses which nonresidents are loath to give up: attorney bar memberships, medical licenses, CPA certifications, licenses for real estate brokers, financial advisers, contractors. The INC system purports only to be concerned about active licenses, so the obvious way to defang this problem is to change the license to inactive status, if that’s possible. If not, a nonresident runs the risk of the FTB starting an inquiry based on an active professional license. But frankly, the risk appears to be de minimis. In twenty-five years of practice, I’ve never seen a 4600 Notice or other residency-related procedure initiated due to license information finding its way to the FTB. That’s why I use the word “purports.” This seems to be braggadocio on the FTB’s part, an attempt to make nonresidents feel they are being scrutinized more closely than they actually are.

But if you are audited, active professional licenses do count against you, so some thought has to go into managing them after moving out of state, even if that means giving up a hard-earned certification.

The Takeaway

The INC system has been around for decades. It sweeps up thousands of nonfiler nonresidents every year. But only a small percentage actually wind up having to file a return or endure a full-fledged residency audit. That said, you win 100% of the audits that never happen, and one line of defense for reducing residency audit risk is eliminating contacts used by the INC system to trigger an inquiry. The boogeyman here is usually an information tax return. Nonresidents should be scrupulous in avoiding a California home address on any such return. Further, any of the contacts that set off the INC system, even the uncommon ones, are for the most part the kinds of contacts a nonresident should avoid regardless, INC or no INC. An ounce of prevention is worth a pound of arguments with an FTB auditor.

 

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Manes Law is the premier law firm focusing exclusively on comprehensive, start-to-finish California residency tax planning. With over 25 years of experience, we assist a clientele of successful innovators and investors, including founders exiting startups through IPOs or M&As, professional athletes and actors, businesses moving out of state, crypto-asset traders and investors, and global citizens who are able to live, work, or retire wherever they want. Learn more about our services at our website: www.calresidencytaxattorney.com.

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